Examination of Witnesses (Questions 160-179)
PROFESSOR MARTIN
CAVE AND
MR ALEX
SKINNER
3 JUNE 2009
Q160 PADDY
TIPPING: Could you give us an
overview of your thinking? Shout me down if I am wrong—I
am sure you will—but in a sense you are taking a reformist
approach to this, "Let's get some competition in. Let's see
how it goes. Let's build on it." Where do you think we will
be in 50 years' time?
PROFESSOR
CAVE: I guess
in a way I have to say I do not know. My hunch is—
Q161 PADDY
TIPPING: Is it about good public
policy?
PROFESSOR
CAVE: The approach
we have taken in the report is sort of captured by the slogan
"Trust and verify", that is to say we think there is
a basis for believing, on the basis of what has been observed
in Scotland and what is happening in other sectors, that competition
is going to be good for consumers. It also has to be made good
for the environment. I think that is very important, that you
have a parallel track that makes sure that happens. In those circumstances
what I think the sensible thing to do is to do a certain number
of things first and then pause and see if they have worked. If
they have worked, then new legislation may be required for the
next lot, and then if those work you might want to do something
else, and so you go on. The logic of this is partly that this
is pretty new stuff, there is not a great deal of competition
in the water sector so far, but it is partly the importance of
trying to build up a constituency in support of competition. I
think it is pretty obvious that people are not walking up and
down Whitehall demanding competition in the water industry.
Q162 CHAIRMAN:
I wish they were. It might take some pressure off us.
PROFESSOR
CAVE: It is
not exactly what is happening. We do know, on the other hand,
that businesses, when asked, "Would you like to have a competing
supplier?" always say in very interesting numbers, "Yes,
we would. We'd like to have a choice." Generally speaking,
people do like to have a choice and I think that is very important,
but we have suggested that we do it in this particular way to
try and get it started, to build up some support and also to overcome
the fact that we do not actually know in full detail how it is
going to work.
Q163 PADDY
TIPPING: You told us earlier on
that you thought abstraction licences were an early priority for
legislation and I can begin to see how trading in abstraction
and community licences might work. Just in simple language for
me, take me through how we would do that. Suppose we legislated.
You would put them out in bids, would you?
PROFESSOR
CAVE: I have
some difficulty with the present market structure of seeing how
trading of abstraction licences would work in the first instance
and it is basically because markets do not work well when almost
everything in the market is owned by one or two parties. So at
the moment almost all abstraction licences are held by incumbent
water companies. So what I would envisage in the first instance,
that being a slightly longer term policy, is that it is important
to put in place measures which enable the Environment Agency to
flex the prices for abstraction and also to deal rather more rigorously
with cases where there is over-abstraction in order to have some
kind of recovery from a situation which is bad at the moment and
might get an awful lot worse in the future. How would flexing
the prices work? If, for example, in water scarce areas the price
of abstraction rose whereas they actually declined, as they could
do, in water abundant areas then people start thinking, "Given
this disparity in prices does it not make sense for us to abstract
here and supply there?" The degree to which they do it would
obviously depend upon the cost of transport. That would get people's
minds thinking along the lines of, "Why don't we see if there
is some smart investment that we could do, using perhaps natural
mechanisms for transporting water around, which enables us to
redress the disparity?" Of course, the other thing it would
do is it would alter the balance of advantage for companies, abstracting
it at very low prices, shoving it through the pipes and selling
it to the consumers as against other measures such as leakage
reduction, because obviously if it is going to cost you more to
abstract you are willing to spend more on leakage reduction, and
also demand management measures, trying to persuade people actually
to consumer less water. I think that kind of use of prices—they
would not be prices in the first instance that would be set by
the market because it is going to take a bit of time to set up
a properly competitive market in abstraction—the use of
prices to give signals to get people to behave in particular ways
which benefit the environment seems to me to be a very good idea.
Q164 PADDY
TIPPING: I have been interested
in abstraction licences for 20 years. I represent an area with
a lot of farmers and it is a sandstone area so there is a lot
of irrigation going on. Whenever there is any talk of legislation
on abstraction licences they go bananas and say, "These are
ours as of right." You are going to have to have powers to
take these "as of rights" away, are you not?
PROFESSOR
CAVE: I will
come on to that in a moment, but in a sense how do you discourage
farmers from abstracting? One is, you take away their abstraction
licences. The other is, you make it more costly for them to abstract.
I am not saying that is going to please them a huge amount if
you did that, but that would be another way of doing it because
it would then be a kind of decision for the farming community,
"What is the best way I can use my land given this new set
of circumstances in order to make a good living as a farmer?"
MR
SKINNER: But
we also met the National Farmers' Union and we did talk to them
about what the potential for trading was and actually they illustrated
to us the scenario which they saw as positive, which is namely
that water companies hold onto a lot of resource because they
are worried about the one in 20 year drought and they said, "Actually,
what could work really well for us is that we come to an arrangement
with the water company which essentially says that for 19 years
in 20 we get to use that water because there is no problem with
supply, and with the trading regime you could do that very easily,
and then for the one year in 20 we would accept the fact that
they would not give us the water and indeed we may even sell our
licences to them for the one year in 20 and they would compensate
us for any impact that had on our crops. That is a win, win for
both of us because the water company does not need to build the
asset because it does not need to make sure it has the water supply
because it can get it from the farmers, and for the 19 years in
20 when there is not a problem with supply farmers can actually
grow more and sell more to market." So they saw that as a
very positive development potentially.
Q165 PADDY
TIPPING: The kind of farmers I
speak to say, "I've abstracted this for my family for years
and years and the licence belongs to me. I've got a legal document
which says it belongs to me." You are going to have to legislate
to take that off them, are you not?
PROFESSOR
CAVE: Well,
either you legislate to take it off them or the Government has
to spend truck loads of money buying it off them, and I doubt
it has much appetite for the second solution.
Q166 PADDY
TIPPING: But this kind of trading
goes on internationally, does it not?
PROFESSOR
CAVE: Oh, yes.
It works basically where there are alternative uses for the water
and there is a lot of participants in the market so that, in other
words, the market is not fixed by somebody just sitting there
and actually controlling it.
Q167 PADDY
TIPPING: So on our next trip away
where should we go and see this abstraction licence trading working?
PROFESSOR
CAVE: Well,
Australia, if that is not too distant a destination.
Q168 PADDY
TIPPING: We are big travellers!
PROFESSOR
CAVE: Australia
is a case where in fact, as I understand it, the Government has
spent a lot of money trying to deal with the problems in the river
system by buying licences.
Q169 CHAIRMAN:
Shorthand for Earl's Court! Could I just go back to the point
Mr Drew raised, which was about cooperation, because one of the
problems about the pricing of water under the current regime is
the difficulty as to who shares the cost and/or burden of, for
example, resilience? It is quite interesting that there are some
water companies who clearly think that is a shareholder responsibility
and therefore the company's money should deal with the resilience
of the asset. There are others who think it should be shared between
the customer and the company and there are others who think the
customer should pay. Resilience is quite a complicated issue in
its own right. How would the payment for that type of contingency
work in with the competitive modelling you have been describing?
In other words, who pays for that and how do you determine who
pays for it in the kind of pricing regime you have been discussing?
PROFESSOR
CAVE: I imagine—and
I have not addressed this question specifically in the report—what
you want to do is to ensure that resilience expenditure was borne
by a component in the value chain which everybody had to use.
In other words, there was no way in which a competitor coming
in could get out of paying his or her whack for the cost of resilience
and get a competitive advantage over anybody else.
Q170 CHAIRMAN:
Would you not, under those circumstances, have to have an agreement
of some kind with all players as to where the responsibility for
that type of expenditure lay because it is an expensive addition
for the sort of normal, run of the mill type of investment that
water companies make? Most of our discussions are about new pipes,
new treatment for dealing with environmental contingencies, that
kind of thing. This, on the other hand, is a cost of doing business.
If you have not got resilience, you have not got a plant; if you
have not got a plant, you have not got anything to supply. You
have got to have some kind of formula to decide where the responsibility
for that lies. The scenario I gave you illustrated that companies
take one of three possible ways under the current model of deciding
where the responsibility is and if your scheme was to work—you
have just said you have got to sort that out and I am not quite
certain how you are going to sort that out.
PROFESSOR
CAVE: In my
understanding it would depend upon which component in the value
chain was actually responsible for incurring the resilience expenditures.
Q171 CHAIRMAN:
I suppose the component is that the water company, to ensure that
it can deliver water to anybody, physical water, has got to safeguard
its "works" and therefore it is the supplier who incurs
a cost, but the reality is who actually pays that cost. As I said
to you a moment ago, from the investigations we have done there
are three scenarios—wholly customer, part customer/part
company, or wholly company. Then to add a further thing, some
companies say, "Well, at the beginning we will have it as
the whole company and then we will sort of migrate some of that
cost back to the consumer."
PROFESSOR
CAVE: I guess
there is a problem here, which is that in order to get people
to invest in the water industry they have on average to get an
appropriate return. People argue like anything about what that
appropriate return is, but clearly if the return gets too low
then the funds just do not come into the sector. So that component
of cost is something which ultimately the consumers have to bear.
Q172 CHAIRMAN:
Let me move to an area which you mentioned earlier, which was
this one of innovation and optimisation of the use of water supplies.
In the work the Committee has done in the energy field we have
seen the debate move from the current format where companies selling
energy services want to maximise their revenue by selling more
of things to a situation where they are having to consider now
selling less of things, so the energy supply company model is
the one that is hoved into view and in our earlier session we
were discussing the way in which the Ofwat Price Review mechanism
did not really have the necessary strength to incentivise a reduction
in the amount of water which was being sold simply because the
company's revenue or business plan as predicated on a reverse
scenario. So in your competitive world how would you see this
juxtaposition between revenue maximisation and water use optimisation
working?
PROFESSOR
CAVE: I think
the development of retail competition is part of the solution.
I am not saying it is the full solution, but it is part of the
solution in the following sense: a specialist retailer which is
just buying the wholesale water and selling it on does not have
any interest in maximising the throughput of water through the
pipes. It is interested in maximising the amount of money it can
make out of its transaction with the customer.
Q173 CHAIRMAN:
Is that not predicated on the fact that you do not have a situation
like they do in gas where you have got "pay and take"
contracts? In gas part of the problem which British Gas got into
was that they had already predetermined how much they were going
to buy and all of a sudden the whole price structure changed and
they could not move off that position. If I have understood you,
earlier on you said that somebody coming into this business would
have to do a negotiation with the existing holder of the rights
to say, "I want to buy so much water," so are you not
in that sort of territory?
PROFESSOR
CAVE: That is
not what I meant to say. I meant to say that somebody coming in
and taking a business customer would then have the right to buy
as much water as that retailer wanted from the network at the
wholesale prices that were established by the regulator. Now,
if the retailer could then make a deal with his customer and said,
"I can think of a very cunning way in which if you do X,
Y and Z you will save so much water," that means there is
going to be a reduction in the wholesale water which has to be
bought. There is going to be a saving and that saving has obviously
got to be split between the retailer who has come up with the
good idea and the customer. In other words by, as it were, dissociating
the retailer from any interest in the quantity of water which
has gone through, because the retailer does not have any connection
with the pipes business or with the treatment business, there
would be opportunities to do that.
Q174 CHAIRMAN:
There are already companies in the country which do help companies
to optimise their water usage on a shared reward basis. They are
already doing it.
PROFESSOR
CAVE: That is
true, but they are not retailers and unless they are brought in
as specialists to deal with that they do not have the opportunity
in the ordinary course of business of saying to their customers,
"Look, why don't you do this?" because simply they do
not have a seat at the table as far as the customer is concerned,
whereas if they were there as a retailer they would have the opportunity
to do that kind of what I might describe as cross-selling.
Q175 MR
DREW: I was with a company, who
shall remain nameless, on Monday which supplies equipment to the
water industry, a major company, a multinational, and one of the
points they made to me was that there is a serious issue with
the Ofwat five year plan because you get this real spike early
on in that period where enormous investment goes into all manner
of different aspects of the water industry, after which you then
get this serious decline in investment spending until you get
another round coming up. This is not a good way to run an industry
because there must be wastage in money early on because there
is a huge spike in investment followed by effectively this year
where there is next to no expenditure. In fact one of the things
they wanted me to lobby for when we talk to Ofwat is to bring
forward the effective spike because in the countercyclical time
we are in that would make eminent sense. But why we are into five
year periods? Who has come up with this? This just seems to again
skew the whole way in which the industry is operating. Did you
see that? Did you find that, because I can see this has an impact?
PROFESSOR
CAVE: No. By
a strange coincidence I was this morning at an innovation day
run by Clancy Docwra, the big contractor, and somebody said exactly
the same thing to me, that they were suffering a downturn in business
from the water sector at the very moment when, for cyclical reasons,
their other business was suffering too and it seems the solution
was to make greater efforts than we have done so far—I know
Ofwat has something to do with this—in order to even out
those demands. I agree with you entirely, I think that would be
a very sensible thing to do, especially in the current circumstances.
Q176 CHAIRMAN:
You have called for more research and you have come up with a
funding formula for that. What are we missing out on in this country
in terms of the output of research to optimise our water usage
and make our waste water more efficient in terms of the way those
processes operate?
PROFESSOR
CAVE: Obviously
I cannot tell you which processes we should be using or which
processes we should be inventing in order to use—
Q177 CHAIRMAN:
No, but you made a statement that more research was needed so
it must be based on some kind of empirical analysis?
PROFESSOR
CAVE: It is
based upon two things, looking at the amount of R&D expenditure
which water and sewerage companies make and it is £18 million
per year in total. That does not seem a great deal of money when
you bear in mind that BT alone spends £1.5 billion on research
and development, although some of that is on software. On the
face of it, the fact that it has declined by more than 50 per
cent over ten years and is very low suggests to me that this is
a thing that is worth looking at. A further consideration is that
we will, I think, quite clearly need more research and development
in order to deal with the environmental conditions and, moreover,
water companies will themselves have to make some rather difficult
decisions about which lines to pursue because they are the ultimate
customer. People say, "Well, there's an awful lot of R&D
going on in the supply chain"—the people whom I was
meeting this morning were offering supplies to water companies
for contracts—but there has to be somebody within the water
company to be able to discriminate amongst all the options which
are available.
Q178 CHAIRMAN:
Do I presume from that then that the current regulatory mechanism
does not exert sufficient pressure on the industry that it must
be researched to live within the means allowed by Ofwat?
PROFESSOR
CAVE: I think
there are two issues here. One is the supply of innovation within
the sector and the other is the demand for it. What does concern
me is that I think the current regulatory regime does tend to
reward with a high degree of certainty doing the same things again
and again, and these are often very capital-intensive activities,
so the money goes into the regulatory asset base and then you
earn a return for a very long period if it is accepted, whereas
your alternative strategy might be to look for something innovative
which might or might not work. If it does not work then under
the present regime, quite reasonably, you take the hit. The question
is, can you flex the rewards that the firms get if it does work?
What we have suggested in the report is that by offering better
returns for innovative investments which succeed you are going
to increase the demand for them by the companies. They will then
try and organise the production of these innovations which they
can then choose amongst by spending a bit more on R&D and
you might be able to get into a virtuous circle. Now, Ofwat has
taken some steps in the current Price Review along these lines,
which are extremely welcome, but the question is, have they gone
far enough?
Q179 PADDY
TIPPING: You just mentioned the
capital nature of the industry and many of the companies are now
quite highly leveraged, but traditionally it has been a fairly
defensive stock because of some monopoly and market conditions
do not change that much. If we move to a more kind of market-based
approach, a more competitive approach, presumably it is going
to be more difficult to get capital and funding from the banks?
Have you looked at that?
PROFESSOR
CAVE: Yes, we
have looked at it with great care because clearly if the impact
of competition was to increase the interest rate by, as some people
said, as much as four per cent—I think that is a bit of
an exaggeration, but if it were that then that would completely
wipe out any possible gains you get from efficiency. So we have
looked at it. We have managed to get together other estimates,
which I think are more realistic, which are much less than that,
but more particularly we have tried to develop this notion of
doing something that does not initially involve very large capital
investment to see if it works, to see what the impact seems to
be on investment sentiment. Always take steps slowly and cautiously,
taking into account the effect on the cost of capital of what
competition might be. That is one of the reasons why I think this
sort of "trust and verify" approach is necessary in
these circumstances because you could blow the whole gains from
competition very quickly just through increases in the cost of
capital.
Q180 PADDY
TIPPING: You mentioned the four
per cent prediction and said that you had done some work yourself.
What is your view about the increase in interest rates?
PROFESSOR
CAVE: I guess
what I am trying to focus on particularly is what the impact of
introducing competition is, not upon what the general level is.
The kind of estimate we have used in our evaluations of what are
the costs and benefit of competition are a possible increase of
between 30 and 80 basis points, that is between 0.3 and 0.8 per
cent. We are thinking that is probably more realistic. Obviously
one has to talk to the investors, that is very important, and
you might have slightly to change the investors if the thing changed
and you might also have to deal with the gearing, but then of
course there might be other pressures in the system at the moment
which would make people look at those gearing decisions in a slightly
different way.
Q181 CHAIRMAN:
Just one last question while you are here. There are one or two
things we might want to write to you about, but in terms of the
qualifying threshold for the special water merger regime you have
commented that that may need to be changed. How?
PROFESSOR
CAVE: Can I
just explain, the reason why we thought it was a good idea to
introduce more pressure on companies through the possibility of
mergers is innovation, because we think that at the moment water
companies tend to be largely immune from mergers. They might be
taken over by another bank, but that is not the same thing. They
are not taken over by their neighbour, who then comes in and spreads
his best practice within the target company. Now, how we would
do it? We came up with various proposals. The first was that as
far as the smaller companies were concerned there would not be
an automatic reference to the Competition Commission in order
to calculate the impact. As far as mergers between two larger
companies were concerned, we proposed that the regulator should
indicate more clearly than has been the case in the past what
the kind of threshold payment would have to be to consumers in
order to allow the merger to go ahead, because one of the problems
which tends to make mergers very difficult at the moment is that
the acquiring party does not know and is unable to calculate in
advance how much it is going to have to put in in terms of consumer
benefits to allow the merger to go ahead. We thought if there
were a greater certainty about what that was then people would
know where they stood and if they thought they were so much better
than the target and they could increase efficiency and gain from
the merger by that means, then they would be much more likely
to go ahead than they are at the moment.
CHAIRMAN: Thank
you very much indeed. I think I understand a little better, but
it is clearly complicated. You have made it very clear that there
is a lot of work in progress and I think we take the message that
you have got to try it bit by bit very carefully to see if it
actually does deliver. I hope that is a fair summary of the main
messages you have given us. There are one or two other points
we would like to write to you about, but thank you both very much
for coming before the Committee.
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